As every investor knows, risk is an essential component of return. Managing and mitigating risk is an integral part of the investment process. Managers, including hedge funds, asset managers, and commodity trading advisors deploy risk mitigation practices across different functions within firms. Even underlying institutional investors, from pension funds to charitable foundations devote significant resources to risk management.
Defining Value at Risk (VaR)
One lens through which we view risk is volatility or the dispersion of returns for an index or security. Higher volatility is associated with increased risk. Volatility though, is a two-way measure, applying to both increases and decreases in price. But investors aren’t worried about upside risk. No one has ever fretted about making too much money. Investors are worried about how much money they could potentially lose. The Value at Risk (VaR) metric can help answer this question. VaR signifies the potential amount of a gain or loss over a given period at a specified confidence level and can be applied at the position or portfolio level.
Understanding the term Margin
To understand why VaR is an important concept, we must take a step back and understand the extremely common but often misunderstood term…Margin.
It is common to hear market participants say they need to meet their “margin requirements” or “collateral call”, but the term carries different meanings in different asset classes.
In equities, for instance, the term margin can equate to leverage. Brokers allow participants to buy and sell equities without paying for those equities in full. For example, if a stock trader purchases a share for $50, with a broker calling for a 50% margin, the trader would only need $25 in the account.
In derivatives markets, margin carries a different connotation. For purposes of this post (and to understand a use case of VaR), let’s look to futures markets as an example. In futures, margin or collateral requirements consist of two unique components: first initial margin, and second variation margin. Initial margin is SPAN (standardized portfolio analysis of risk…more on this in a minute). Variation Margin is mark-to-market fluctuation. That’s to say if the price of a futures instrument decreases the day after the initial purchase, a participant would need to post the difference between the purchase price and the second day’s closing price on the third day.
SPAN and VaR
To understand how initial margin is computed, we need to understand SPAN. The Chicago Mercantile Exchange developed the calculation which has become a global standard (with slight variables) and is in the process of revamping to account for modern market risks via SPAN2 (SPAN 2 Methodology (cmegroup.com)). Both SPAN and SPAN2 are VaR calculations with nuances, most importantly of which, SPAN2 includes stress simulations reminiscent of recent market events.
Anticipate Margin Requirements with Post Trade Processing Systems
Markets operate with checks and balances which is why end-users need to have the ability to not only check their broker’s margin calls but also have an understanding of how different positioning and product usage may impact their margin requirements.
While it’s possible to create an in-house system capable of calculating Value at Risk, this can be complicated and expensive both to build and maintain. A better alternative is to use a post-trade processing platform that offers this capability as a part of a larger analytics package. The best packages will offer flexible solutions that allow for multiple methods of calculation. Moreover, as many of these packages are available in Saas format, the cost savings can be considerable.
About the Author
Rebecca Baldridge, CFA, is an investment professional and financial writer with more than 20 years of experience in creating content and research for asset managers, investment banks, brokers and other financial services clients. She’s worked for some of the biggest names in the industry, including Merrill Lynch Asset Management, JP Morgan Asset Management, BNY Mellon and Franklin Templeton. Rebecca also spent 9 years as an analyst and director of equity research in Moscow, working for several Russian banks. In late 2019, she founded Quartet Communications, a boutique communications firm serving financial services clients. Her writing has been published in outlets including Pensions & Investments, MSNBC.com, Inc. magazine, and Investopedia.com. She holds a B.A. in Russian from Purdue University and an M.S. in Finance from the Krannert Graduate School of Management at Purdue.